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Costco, one of my favorite companies (and one I am invested in), announced that it would be paying out a special dividend ^[3] that would total more than $3 billion based on the number of shares outstanding. Companies don’t often pay out special dividends but given the uncertainty of tax rates next year, Costco is one of several companies paying out a special dividend in 2012, rather than 2013.

This highlights one of the long running myths of dividend investing – that you can buy a stock just before it pays out the dividend and then profit from it. It’s known as buying the dividend and it doesn’t work.

Unfortunately it’s not true. A broker might tell you that it’s a good strategy but it’s not for two reasons:

1. When a stock pays out a dividend, the stock price falls by the exact same amount. The argument is that because the cash is leaving the company, the shares are worth that much less. If you get $1 per share of stock, expect the stock to fall $1. The stock may recover some of that loss for other reasons but you don’t profit from the dividend directly.
2. Taxes! Let’s say you buy a share of Bargaineering for $100 today, a day before we pay out a $5 dividend. Tomorrow, I hand you a crisp five dollar bill and a share is immediately worth $95. You owe Uncle Sam taxes on that $5 I just gave you. In fact, if you don’t hold the stock for 60 days (60 days of the 120 days before and after the dividend), you don’t even get favorable tax treatment on that payment.

If you like a company and want to invest in it, it’s best to do it on the ex-dividend date (the day after the day of record, so you won’t get the dividend) so you pay a lower stock price and avoid taxes what is, ostensibly, getting your own money back.

There are no free lunches!

(Photo: amagill ^[4])